Federated Investor's Senior Equity Strategist, Linda A. Duesse discusses oil prices, earnings, election years, the Santa Claus Rally (SCR) and more in her 2016 Outlook.
"As an indecisive year draws to a close —the S&P 500 crossed the flat line a in 2015—the market
record 26 times remains in a difficult position. While the seasonal backdrop is certainly supportive through January, daily, weekly and monthly momentum indicators are not oversold and continue to weaken. Individuals continue to dump equity funds, market breadth remains narrow, the rally off the August lows failed to generate the internal surge often seen in the early innings of a durable advance, and credit conditions are still suggesting caution, with high-yield spreads ending 2015 at their highest level in nearly 3 years. The macro backdrop isn’t great either. Global growth is slowing, while in the U.S., real GDP remains stuck in a 2%-2.5% rut. Ironically, the ability of companies to make money in this environment may be supportive of this frustrating norm. While the top line of developed-market companies has been rising much slower than in previous recoveries, profits have grown at a very decent pace, a result of operating leverage that has grown steadily over the last quarter century. In other words, companies have learned to generate profits in a low-growth environment and have been successful at expanding margins. One of the key reasons, Empirical Research says, is the improved use of capital, i.e., with returns on capital improving, margins can improve without the capital intensity typical of past cycles. A consequence is that a capital-light business model comes with a capital spending-light recovery, which means the accelerator effect on GDP from that spending will be muted and the recovery is destined to remain sluggish.
Two divergences are worrisome: one is the widening gap between earnings and sales results. The proportion of companies beating on earnings per share (EPS) was 60% in Q3 2015, the highest in five years, while the proportion missing on sales (59%) was the highest in three years—with the gap between the two ratios the widest since Q1 2009. Another trend worth watching, Bank of America says, is pro forma (adjusted) vs. reported S&P EPS. Since late last year, adjusted EPS has exceeded reported EPS by more than 30%, well above the 10% gap for most of 2013 and 2014 and the widest since the global financial crisis. Nearly 60% of the difference was attributable to the energy and metals, mining & machinery sectors, where asset impairments/write-downs were the biggest contributors. Another 20% of the difference was related to heath care (chiefly pharma, biotech and equipment/supplies), largely due to acquisition-related costs/impairments. Consensus is calling for 18% EPS growth next year vs. the long-term average of 8.5%, with a weaker dollar helping multinationals with overseas earnings translations. From a sector perspective, reaching consensus would likely require the energy sector to return to profitability—consensus expects energy to swing from a $2.76 per-share loss in 2015 to a $16.23 profit in 2016. But the potential for lower-oil-prices-for-longer calls this rebound into question. Should the same factors that drove down earnings in 2015 remain in place in 2016, EPS could struggle to grow at all, JP Morgan says.
When we look at history, we do not have good evidence of a decline in oil prices leading to a U.S. recession—in fact, it’s just the opposite: oil prices very frequently cause recessions. There are certainly still stress points abroad. But rising when looking at the global recessions of the past 40 years, Strategas Research finds the U.S. has tended to be in recession first. That makes sense, given that U.S. consumers have tended to be a key source of end demand. There are lingering risks as we start the New Year (still weak commodity prices, China’s currency weakening, elevated corporate credit spreads, geopolitical instability). Moreover, S&P transports—a good market/economic indicator—have been weak. But if oil can stabilize and if investors can gain more confidence on China’s economy (slowing but not collapsing), then 2016 should look better overall. Clearly, the U.S. consumer is starting 2016 in the best shape in years (see more about this in my special). Unemployment is at a 7-year low; gasoline is cheap, interest rates are still low even with Fed liftoff and report next week wages are rising. On the macro front, housing looks to be recovering, autos are going strong and services are still expanding despite manufacturing’s woes. If consumers keep buying homes and cars, it’s hard to argue there’s too much wrong. Even the government is set to be a contributor—its new fiscal budget and tax package is expected to add 70 basis points to GDP in the coming year, an election year (more below). As the Fed raises rates at a turtle speed in 2016, instead more below of focusing intensely on minor tail risks, investors may well come around to the view the economy is moving closer to full capacity and that life is indeed getting better. I see the turtle, still dragging that heavy wallet full of dividends, walking by with his hat and horn, ready to celebrate the New Year..." Download below to read full report.
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